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Interest Rate Update: To Raise or Not To Raise

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The Federal Reserve is at something of a crossroads heading into its June meeting. Our economist, Matt Erickson, looks at the state of the economy and how it could shape the Fed’s action on interest rates in coming months.

Summary Points

  • Declining prices for many major commodities and contraction in the manufacturing sector point to a continued slowdown in the U.S. economy.
  • The U.S. job market remains resilient. The U.S. added 339,000 jobs in May, well above the market expectation of 190,000.
  • Markets predict the Federal Reserve will maintain its current benchmark rate at its June meeting, followed by an increase in July.

Why This Matters

The Federal Reserve meets June 14. Since March 2022, the Fed has raised its benchmark rate 10 times for a total of 20, 25-basis points in an effort to tamp down inflation. The current benchmark rate is 5% on the low end and 5.25% on the top end. The prime rate stands at 8.25%; it has maintained its historical 30-year spread with the federal funds rate.

The higher rate environment continues to impact the U.S. economy. Three high-profile bank failures earlier this year and a slowdown in areas of the economy, including the manufacturing sector, can be tied to higher rates. The labor market and U.S. consumer spending, however, have proven more resilient.  

Is the Federal Reserve at a crossroads on rates? Let’s investigate the economic variables at play as the Fed weighs pausing or increasing rates, and how they could shape Fed decision-making in June and beyond.

The case for pausing rate hikes centers on the evidence that the U.S. economy is slowing and the fact that rate hikes take time to filter through the economy. As table 1 shows, the price for many major commodities has declined significantly the past six months. External factors such as weather and geopolitical concerns have contributed to volatility in commodity prices. But the slowing economy also has meant a pullback in demand. Look no further than the diesel market. At a time when ending stocks are extremely low, diesel prices continue to decline due to lower activity from the manufacturing and transportation sectors.

Table 1. Six-Month Change to Key Commodity Prices

CommodityHigh from January 2023First of June 2023Six-Month % Change
Crude Oil ($/bbl.)$81.62$69.45-14.9%
Diesel Fuel ($/gal.)$4.62$3.80-17.7%
Natural Gas ($/MMBtu)$3.78$2.10-44.4%
Corn ($/bu.)$6.06$5.30-12.5%
Soybeans ($/bu.)$13.97$11.69-16.3%
Wheat ($/bu.)$7.86$6.10-22.4%
Copper ($/lbs.)$4.27$3.72-13%
Lumber ($/1000 board feet)$622.50$473.00-24%
Data Sources: Energy Information Administration, CME Group and Nasdaq

In general, the manufacturing sector’s share of real GDP is between 11% and 13% - a significant contributor to U.S. economic growth. Although U.S. manufacturing activity picked up 1% from March to April, it was down 0.9% year-over-year. Higher interest rates and borrowing costs have slowed output. So has the appreciation of the U.S. dollar, which makes U.S. commodities more expensive for foreign purchasers. Last October, the U.S. Dollar Index peaked 23% above March 2022 levels. Today, it is 13.1% higher than at the start of the rate cycle.  Other data suggesting a slowdown in manufacturing includes the ISM Manufacturing Index. The index showed contraction in May for the seventh consecutive month as new orders continue to decline. Regionally, the manufacturing indexes from the Federal Reserve Banks of Dallas, Kansas City, and Richmond were flat to contractionary in May:

  • Dallas Fed:-29.1 (The lowest reading in three years.)
  • Kansas City Fed: -1
  • Richmond: -15

The Fed’s interest rate hikes have a lagging effect on the U.S. economy. This means that while some impacts, such as layoffs in the technology and finance sectors, have surfaced, the full weight of the hikes hasn’t hit the economy. Heading into the Fed’s June meeting, many in the marketplace favor a pause in rate hikes to allow more data on the state of the economy to surface.

The case for further rate hikes rests on a labor market that remains hot, continued spending by consumers and inflation that outpaces expectations.

First, the labor market. May payroll came in stronger than market expectations: 339,000 actual vs. 190,000 expected. Monthly job creation in the U.S. increased for the 29th straight month. Hourly earnings growth for the month stood at 0.3%, as expected, and the unemployment rate was 3.7%, notable as the 16th consecutive month that unemployment was below 4% and the longest such stretch since the late 1960s and early 1970s. Currently, the U.S. employers have 1.79 job opening per one unemployed person. In fact, while job openings in April declined 16% from the March 2022 peak, they remain 44% above pre-pandemic levels. Low unemployment continues to keep the consumer in a strong position.

In the first quarter of 2023, total consumer debt hit a record high, exceeding $17 trillion. While delinquencies on credit cards, auto loans and mortgages is trending up, the sustained strength in real personal income is generally supportive of spending and is a challenge for the Federal Reserve. As Figure 1 shows, year-over-year real personal income has increased three consecutive months and is currently 1.2% higher than levels from April 2022.

Figure 1: Real personal income (less transfer receipts) year-over-year percentage change since 1960

The April Personal Consumption Expenditures (PCE) report found an uptick in consumer spending and inflation. The core PCE price index rose 0.4% in April and 4.7% from a year ago, both exceeding the markets expectation ahead of the report.

Despite the higher inflation rate, personal spending jumped 0.8% for the month while higher real personal incomes rose approximately 0.1%. On an inflation-adjusted basis, as shown in Figure 2, consumer spending continues to grow for both goods and services. Adjusted for inflation, consumer spending grew about 2.5%, indicating significant demand still working its way through the economy. These are signs that inflation isn’t coming down quickly.

The good news? The latest data holds minimal signs of recession. The bad? It adds to the argument that the Fed has more work to do to bring inflation under control.

What does this mean for producers?

On one hand, the slowdown in the U.S. economy has delivered much needed price relief for some input costs, such as diesel and natural gas. At the same time, the labor market and consumer spending remain resilient – and this is a major point of concern as the Fed considers the future of rate hikes.

Figure 2: Real personal consumption expenditures (year-over-year): for January 2022 to April 2023

Markets currently put the chance of a rate pause at the June meeting at approximately 75%; the chance of a 25 basis-point increase stands at about 25%. The chance of a 25 basis-point increase is higher for the July meeting, when the CME Fed Watch Tool projects the rate cycle peaking between 5.25% and 5.5%. If the 30-year spread with the prime rate holds, it would put prime between 8.25% and 8.5%.

The market also projects rate reductions later this year. While the June and July predictions seem likely, the expectation for lower rates merits caution for three reasons:

1) The Fed has given no indication it plans a rate reduction in 2023.

2) It is too early to talk about a reduction when we may not have seen the peak in rates. More data needs to be analyzed in the months ahead. The Fed leadership will renew its economic projections during the June meeting, providing some additional insights.

3) The Federal Reserve’s dual mandate is to achieve “maximum employment” and “stable prices.” Economic growth, specifically, is not a policy goal of the Federal Reserve. It is clear from the labor and inflation data that the Fed may have more work to do to tame inflation, even if it is at the cost of slower economic growth.

By all accounts, the primary goal of the Federal Reserve should be to avoid the economic events of 1980. If this moment in history taught us anything, it is the huge economic cost that can be inflicted by a Federal Reserve that reverses course before containing inflation. Additionally, the Fed can only achieve its goal of maximum employment if it is successful in achieving price stability.